On Our Radar

On Our Radar

A Look at Kinder Morgan Inc.s Surprisingly Shrinking Backlog

Kinder Morgan recently reported pretty decent fourth-quarter results. The only weak area was the company's carbon dioxide business, which was affected by lower oil prices. That said, there was one more area that was a bit concerning and that's the company's backlog, which actually shrunk a bit. Because its backlog is so important to future growth this is certainly worth a closer look.

Continue Reading Below

Breaking down the backlogAs of the end of the third-quarter Kinder Morgan's five-year project backlog stood at $17.9 billion as we see on the following chart.

Source: Kinder Morgan Investor Presentation.

However, the company announced that its backlog is now down slightly to $17.6 billion as of the end of the fourth quarter. That's still quite robust, but it's obviously heading in the wrong direction.

That said, one of the reasons why the backlog is lower is due to the $730 million in projects it placed into service during the quarter. That's actually less than the $1 billion it planned to place into service according to what's noted on the backlog slide above. However, ideally we'd like to have seen the company add at least as much to its backlog as it placed into service as it suggests that Kinder Morgan's growth won't slow in the years ahead. So, the good news is that the company did just that as it added $1.24 billion in new projects to its backlog.

Continue Reading Below

ADVERTISEMENT

The issue with the backlog is the fact that the company also removed $785 million in projects, which is what caused it to shrink. The company noted that these projects were, "primarily in the CO2segment that have been delayed beyond the time horizon of the backlog due to lower commodity prices." What this means is that the company has decided to delay some of its oil projects in the 2017-plus bucket as the returns from these projects aren't appealing at current oil prices. So, until oil prices pick up, the company will simply hold off on these investments.

Goodman Point. Source: Kinder Morgan.

Risk and rewardAs investors know quite well the bulk of Kinder Morgan's assets are backed by long-term, fee-based contracts. It's oil business, on the other hand, is not and is only protected by its oil hedges. These hedges help to mute the impact of oil price volatility in the short term, however, there isn't much the company can do for long-term protection. Because of this, Kinder Morgan insists on higher returns when it invests in new oil projects to compensate for this higher risk. This was noted by CEO-to-be Steve Kean at a recent investor conference as he said:

The reason that the rate of return is higher there is, quite frankly, we focus on the projects that will -- because we are exposed to commodity price risk in that business, we focus only on those projects that generate a 20% or better rate of return on the oil price assumptions that were used at the time. And then, you see the track record there of historical performance. We've been able to do a little bit better than that, but some of that has been, over this entire period, a generally uplifting oil price.

As Kean points out, the company is looking to make at least a 20% rate of return when it invests in new oil projects based on the oil price assumptions it's making at the time of investment. With oil prices down about 50% to around $50 per barrel the company can simply no longer plan on earning a 20% return on these projects. So, until oil prices pick up it's putting these investments on the back burner. The oil is still there and Kinder Morgan knows how to get it out, but it's not going to invest the money needed to extract that oil unless it's fairly certain that it will be well compensated for the extra risk that comes from oil price volatility.

Investor takeawayThe reason why Kinder Morgan's backlog dipped in the quarter is vitally important. If the company lost a key pipeline contract then there'd be reason for concern. However, this isn't the case as the company is just deferring investments on new oil projects until it can be certain that it will earn a high enough return to justify the investment risk.

Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan because I think a leveraged bullish bet on Kinder Morgan will really pay off over the long-term. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.